UBS now expects two Fed rate hikes, sees equity outlook intact

UBS distinguishes between a Fed tightening due to economic strength and one reacting to runaway inflation, arguing the former scenario leaves its bullish equity stance unchanged.

The difference is key for portfolio positioning: tightening in an environment of robust GDP, AI investment and strong employment has historically underpinned risk assets despite short-lived volatility, while hikes triggered by worsening growth and inflation would be interpreted very differently. UBS applies this reasoning to advise clients against using the rate trajectory as a justification for reducing risk, maintaining its preference for equities tied to AI, power and resources, and longevity themes throughout the rate-hiking cycle.

For bonds and the dollar, the outlook is less clear-cut: elevated yields diminish the appeal of holding short-duration bonds compared with cash, while medium- to long-duration quality bonds are seen as providing both yield and a hedge against a potential growth slowdown. The US dollar should gain near-term support from the more hawkish policy direction, but UBS cautions that this support would diminish if the rate increases are driven by inflation rather than economic strength. Equity investors are told to view any turbulence surrounding the CPI release and the Fed meeting as an opportunity to realign portfolio weights with targets rather than a reason to pull back.

UBS's core message is that the Fed is shifting hawkish due to robust economic conditions, not because any part of the system is fracturing, and it is that differentiation that should maintain a positive bias among equity investors.

• US nonfarm payrolls increased by 162,000 in August, with private payrolls climbing 127,000 against a consensus of 55,000, and prior months revised up by 55,000
• The unemployment rate remained at 4.1%, as job gains were counterbalanced by increased labor force participation
• July PCE inflation exceeded forecasts at 3.7% year-on-year, accompanied by a hawkish tone from Fed Chair Warsh at Jackson Hole
• Following the data, market probabilities for a September rate increase climbed from about 50% to approximately 60%, while the S&P 500 dipped just 0.4% on the same day
• UBS dropped its earlier baseline assumption of steady rates through 2026 and now forecasts two quarter-point rate increases, one in September (meeting on the 15th and 16th) and another in December (8th and 9th), raising the fed funds range to 4.00%-4.25%
• UBS lifted its 2-year Treasury yield projection to 4.25% by June 2027 and its 10-year forecast to 4.5%, while keeping a positive stance on global equities and maintaining its focus on AI, power and resources, and longevity themes

UBS has reversed its earlier view that the Federal Reserve would keep rates unchanged through 2026, instead now predicting two 25-basis-point hikes in September and December, following a better-than-expected August jobs report that capped a series of hawkish developments. Nonfarm payrolls grew by 162,000 in August, with private payrolls adding 127,000 versus a consensus of just 55,000, and upward revisions contributed an additional 55,000 to earlier months. The jobless rate stayed at 4.1% as employment increases were balanced by higher labor force participation. Equities shrugged off the data, with the S&P 500 falling only 0.4% as two-year Treasury yields and the dollar strengthened, an early indicator UBS views as aligning with its overall narrative.

UBS cites three factors behind the shift. Fed Chair Kevin Warsh struck a more hawkish note at Jackson Hole, insisting that underlying inflation must move clearly and swiftly toward the 2% target, a benchmark UBS expects the upcoming CPI data to still miss on a core basis. Supply chain constraints highlighted in recent ISM and PMI reports have increased upside inflation risks, with UBS also pointing to early indications that AI-driven demand could be expanding. Lastly, the robust August jobs data itself indicates that current policy is insufficiently tight to reduce inflation without additional rate increases.

UBS's main argument, which it urges equity investors to heed, is that the context of the rate hikes is more important than the hikes themselves. Tightening in an environment of genuine economic strength, resilient activity, AI-related capital spending, and solid employment has historically been favorable for risk assets, despite occasional turbulence around data releases. This stands in sharp contrast to a Fed hiking due to stubborn inflation accompanied by weak growth, a scenario UBS says would be much less positive for equities. Therefore, the bank retains its constructive global equity view throughout the tightening cycle, continuing to prefer sectors such as AI, power and resources, and longevity themes, all of which it expects to benefit from higher investment and structural growth.

The outlook is more nuanced for assets beyond equities. UBS has raised its own yield projections, now forecasting two-year yields at 4.25% by June 2027, one percentage point above its earlier estimate, and 10-year yields at 4.5%, a 40-basis-point increase, and notes that the rationale for preferring short-duration bonds over cash has weakened as a result. It sees improved diversification opportunities further out on the curve, where medium- to long-duration quality bonds can provide both income and protection if growth decelerates. The US dollar should gain near-term support from a more hawkish Fed, especially if the policy divergence with other central banks grows, but UBS warns that this support would weaken if the rate increases are inflation-driven rather than growth-driven.

For equity positioning specifically, UBS characterizes the period ahead of the Fed's September 15-16 meeting and the August CPI report due September 11 as an opportunity to act rather than a time to stay on the sidelines. Volatility surrounding these events is portrayed as a chance to adjust portfolio allocations toward targets, including buying equity dips if earnings prospects remain sound, rather than as a justification for cutting risk before the decision.